WHAT IS MONEY
Generally, anything which is accepted as a medium of exchange can be considered money. Money has followed a natural evolution, culminating in the fiat money used in modern economies. Fiat money is considered legal tender, but it is not legally convertible, or “backed”, by a commodity such as gold or silver. Fiat money, in other words, is a true “paper” money system.
In the absence of money, people would exchange goods and services directly for other goods and services through barter. While the earliest societies had relied to a greater degree on bartering, the practice persists in limited form even in modern times. It is unclear how much economic exchange takes place in the form of barter, but it can easily be observed that relatively small goods and services are frequently directly exchanged (i.e., without the medium of money).
No society has ever completely relied on barter as a system of economic exchange. This is largely because barter represents an awkward and impractical form of exchange. Particularly, barter requires a double-coincidence of wants in which both parties in a potential exchange must want what the other is offering. While this problem could be, and often was, partially relieved through organized marketplaces, only limited transactions could occur in a barter system.
Another flaw in the barter system is the complexity of prices. In a barter system, the “price” of each good or service must be quoted relative to all other goods and services. When multiple goods and services exist, the number of prices for a single good or service is immense.
THE FUNCTIONS OF MONEY
The main functions of money are to act as a: medium of exchange, store of value, and unit of account.
Money’s most important function is to serve as a medium of exchange. This means that money can be used as payment for goods and services. As a medium of exchange, money helps facilitate the efficient transfer of goods and services.
Money acts as a store of value when people are reasonably confident that money can purchase in the future what it can purchase today. Thus, money should allow people to defer their purchasing power. Money also promotes specialization by allowing individuals to exchange their labor for money.
Money as a unit of account eliminates the need to quote goods and services in terms of other goods and services. When a society uses something universally accepted as money, people don’t have to say, for example, that one hardback novel is worth one steak dinner, or that an exotic sports car is worth one condo. In the U.S., we can quote all goods and services in terms of dollars.
MEASURES OF MONEY
The Federal Reserve is the central bank of the United States. Through policies which we will explore in a later article, the Federal Reserve has a great deal of influence over the total amount of money in the U.S. economy. The money supply refers to the total quantity of money in the economy. The money supply consists primarily of currency (coins and bills) and deposits held at financial institutions.
The two most widely followed measures of the money supply are M1 and M2. M1 is the narrowest measure of the money supply, and consists of currency, travelers’ checks, demand deposits (checking accounts), and other checkable deposits. A broader, and perhaps more useful, measure of the money supply is M2. M2 is everything included in M1, plus small time deposits, savings and money market deposits, and money market mutual fund shares.
Mishkin, Frederic S. The Economics of Money, Banking & Financial Markets, 2nd ed. New York: Addison Wesley, 2010.